Know the Rules

Employee stock options can provide you with a substantial source of deferred income and permit you to control the recognition of taxable income. You generally pay no tax when an option is granted because you are not receiving any shares of stock, only the option to purchase shares at a later date.

In general, holding an option to acquire stock may be better than holding the stock itself. The option provides protection against loss should the value of the stock decline below the exercise price. In addition, the option gives the holder equivalent ownership rights in the corporation, without requiring any immediate investment. Employee stock options offer the potential to have post-exercise stock growth taxed as capital gains rather than ordinary income. This provides an advantage for those who are in the top tax brackets

Know the Difference

Nonqualified Stock Options (NSOs) give an employee the option to buy corporate stock at a specified, fixed price (usually at fair market value at the time the option is granted). In general, you must exercise your option to buy within a specified time period--typically 10 years or less.

Upon exercising your rights, any gain realized from the spread (the difference between the exercise price and the fair market value) is taxed as ordinary income. However, any gain realized from the date the option exercised until the date the stock is sold is taxed as capital gain.

Incentive Stock Options (ISOs) also offer the option to purchase corporate stock at a set price, but ISOs cannot be issued with an exercise price below the current fair market value of the stock.

Generally, the spread on ISOs is not subject to ordinary income tax at the time you exercise the option. However, spreads may be subject to the alternative minimum tax (consult your GROCO financial adviser for more information). Gain realized upon the sale of the ISO stock may be taxed as capital gain. Provided you have held the ISO stock for at least one year from the date of exercise and at least two years from the date the option was granted, the entire gain recognized upon sale of the stock is taxed as a long-term capital gain.

When to Exercise Your Options

The decision of when to exercise your options depends on several factors as well as your particular situation:

Your Company's Plan

Generally, options become exercisable over a period of years. For example, options granted in the company plan vest 20 percent a year over five years. It's important to know the details of your firm's plan before you make a decision.

Your Company's Growth

Understanding how your company is poised for growth is another important factor in your decision making process. Issues to review and understand are:

• How your company makes money understand the industry that their earnings are tied to.

• Evaluate sales compare your companys sales to the industry average of competitors.

• Industry trends monitor the industry that your company operates in. Look for growth opportunities and understand your companys strategy for capturing market share.

• Understand the factors that can affect the liquidity of the market are lower interest rates and tax cuts freeing up resources for the companys growth plans?

• How your company is financing growth are they growing as expected?

• Know your leaders and their track record a companys strong executive team will likely yield continued success.

• Understand your companys P/E (price to earnings) ratio look for strong cash flow and well-managed costs.

Your Current Financial Needs

The decision to exercise should consider the need for cash, the proximity to the option's expiration and/or the current stock value as compared to its expected future value. With regard to ISOs, because of taxes, the required holding periods should be considered when determining when to exercise the options and/or sell the underlying stock.

Balancing Your Portfolio

You may also choose to exercise an option if your company's stock represents a large portion of your investment portfolio and you wish to diversify your holdings. Some professionals say to reduce investment risk, company stock should not represent more than 40 percent of your portfolio.

Market Conditions

Obviously, market conditions will play a large role in your decision to exercise your option. If the stock underlying the option appreciates, you may wish to hold on to options as long as possible in order to take advantage of future gains.

Tax Ramifications

In the case of NSOs, you may want to consider exercising your option over a few years to avoid being forced into a higher tax bracket. Remember, the spread on NSOs is subject to regular income tax at the time of exercise. Because appreciation occurring before exercise is taxed as ordinary income, it may be advantageous to exercise over time.

Your company's nonqualified stock options may be transferable to family members. If so, you may be able to trim your estate tax by giving options to your heirs. The transfer may be gift tax free if the value transferred is $11,000 or less ($22,000 if married). notwithstanding the transfer, upon exercise the executive will be responsible for any income taxes generated.